A Greenspan Exit Strategy

Fortune issue: August 2, 1999


First Principles

A Greenspan Exit Strategy

By N. Gregory Mankiw

After the Federal Reserve Board hiked interest rates only a quarter of a percentage point and hinted that that would suffice, everyone was loving Alan Greenspan. He applied the brakes to the surging economy, but not too much. His monetary policies have steered us through boom times that keep booming.

But nothing can last forever, including the Fed chairman. After all, Greenspan is 73 years old, and Wall Street lives in fear that he might run after one drop shot too many on the Fed's private tennis courts. Perhaps it's time for Greenspan to consider putting in place an institutional framework that might survive his tenure.

Imagine that the Fed chairman steps down someday, and his successor wants to continue the Greenspan policy. How? Greenspan is famously opaque when it comes to explaining what he's doing. He studies statistics like tea leaves and makes inscrutable pronouncements. The outcome has been the lowest inflation and unemployment in a generation--luckily.

I say that because luck has been a large part of Greenspan's success. When he took over at the Fed in 1987, the U.S. economy was in great shape. Paul Volcker had put the economy through a disinflationary wringer. Then, just before Greenspan stepped in, OPEC squabbling depressed world oil prices, which reduced inflation further and stimulated growth.

Greenspan's luck has held over the past few years, when inflation has stayed low despite a strong economy. Some pin this on falling commodity prices resulting from the Asian slump. Others say an aging labor force and fear of downsizing mean that low unemployment no longer boosts wages.

I wonder how Greenspan would react if faced with the events of the 1970s. Imagine he had inherited rising inflation due to an unpopular war, and then had had to deal with two doublings in world oil prices within a few years, all on top of a slowdown in productivity growth and rising unemployment. Would he have avoided the double-digit inflation of that era? Who knows? What's clear today is that Greenspan's luck could evaporate.

Or maybe not. Maybe he has a system here that he's just not revealing. I would like to think that Greenspan has quietly adopted a policy called inflation targeting. This policy has been openly embraced recently by many of the world's central banks--from places as disparate as Britain and Brazil--hoping to suppress inflationary temptation. Perhaps it's time for the U.S. to join the club.

Here's how it works: Greenspan would announce a target range for inflation--say, zero to 2% per year. When inflation looks as if it's falling below that range, he cuts interest rates and expands the money supply. When inflation rises above the range, he does the opposite.

This policy would be giving clear signals if he was openly using it now. Take, for instance, my favorite barometer of future inflation--the spread between Treasury bond yields with and without inflation indexation. This spread has risen from less than a percentage point last fall to about two percentage points today. Consistent with this, many economic forecasters also predict rising inflation next year. If the Fed were targeting inflation between zero and 2%, it would be time to nudge interest rates a bit higher by slowing money growth.

So if that is what he's doing, it would be nice if he'd admit it. He certainly need not worry about his job. If he confesses to inflation targeting, it's not as if they're going to replace him with a computer program. But openly adopting such a policy would help keep the Greenspan economic "luck" going. And then he could rush the net on the tennis court all he wants.


N. GREGORY MANKIW is a Harvard economics professor and author of Principles of Economics.